The Trade War Playbook

The US administration appears to be taking an increasingly aggressive stance on trade; however, as BNP Paribas notes, the impact of trade tensions on capital markets can be ambiguous and vary over time…

As BNP’s Daniel Katzive details the USD has tended to react negatively to aggressive trade headlines, but second and third round effects could be positive.

Below BNP highlights three transmission channels from a shift towards more aggressive US trade policy to exchange rates. As the discussion indicates, the influences are not all in the same direction for the USD, and the net implications may be ambiguous over time.

Stage 1 –Protectionism = devaluationism: The USD’s tendency to weaken broadly on news of new tariff measures implicitly reflects a view that a preference for increased trade protection goes hand in hand with a preference for a weaker USD. This may reflect the logic that improving the US trade balance materially, which seems to be a key metric for the administration, will be impossible with the current elevated levels of the USD exchange rate. It may also be a function of the history of US trade policy dating back to the auto disputes with Japan in the 1980s and early 1990s, when US efforts to protect the auto industry were associated with a perceived preference for a weaker USD. The USD has already been under pressure over the past year as global investors seek to reduce exposure in anticipation of a structural peak in the currency. Against that backdrop, concerns that the US administration is actively seeking a weaker currency could hasten efforts to hedge USD exposure. Indeed, the market’s strong reaction to seemingly innocuous comments in January from Treasury Secretary Mnuchin on the trade benefits of a weaker USD are consistent with this. This dynamic suggests that headlines indicating further steps towards increasing tariffs will be met initially with broad USD selling, particularly in core G10 pairs such as USDJPY and EURUSD.

Stage 2 –Impact on risk environment. An important check on the tendency of the USD to weaken on news of aggressive US trade measures relates to impact of negative trade news on the broader risk environment. It is not clear how much, if any, of the early February shakeout in risky assets reflected protectionism concerns. However, with major corporations having developed business models and supply chains in an era of steady increases in global trade, it seems reasonable to expect some negative impact on the risk environment if global trade relations deteriorate markedly. As we saw in early February, extended short USD positioning and the use of the USD as a funding currency during periods of improving risk appetite means that the USD can rally significanlty now during periods of market stress. A very negative reaction in global equity markets could overwhelm initial negative effects on the USD, at least temporarily. USD gains would be particularly notable versus risk sensitive commodity exporter and EM currencies, but stretched short USD positioning means that even EURUSD would likely decline and even USDJPY might be more stable than many would normally expect.

Stage 3 –The end game.The ultimate economic impact of US trade measures will depend upon the response of other major trading partners. In isolation, increased US trade barriers would tend to reduce the US trade and current account deficits, reducing the US financing requirement and supporting the USD. Higher import prices might also tend to support inflation, allowing more Fed tightening and higher US rates than otherwise. Of course, other trading partners could respond to US actions with protectionist measures of their own, impacting US exports and resulting in a decline in global trading activity more broadly. The impact on the global economy of a ‘hot trade war’ is difficult to model. But the US is considerably less exposed to trade than other G10 economies, as Chart 3 shows, implying the US might have less to lose than other economies from a deterioration in global trade. Indeed, uncertainty over NAFTA negotiations has already been a factor keeping the Bank of Canada cautious, helping to keep the CAD capped.

Bottom line. News of more aggressive trade policy measures from the US administration would likely be met initially with an intensification of depreciation pressure on the USD. However, second and third round effects might be more supportive for the USD and ultimately benefit the currency. Our base case forecasts assume that, while news of more aggressive trade measures will periodically weigh on the USD in the months ahead, we will avoid the very damaging trade war scenarios which could lead to the second and third round effects outlined above. However, uncertainty on the trade front remains a significant risk to our bearish USD forecast profile for 2018 and 2019.

Consider the following 5 points that bind President Trump, his recently announced steel/aluminum tariffs, and the US stock market:

#1. Since his election President Trump has often tweeted about the rise in US stock prices, often citing the Dow Jones Industrial Average as his reference point.

#2. Boeing has the largest weighting in the Dow, at 9.8%. That is more than the combined influence of Apple, Amazon and Microsoft on the S&P 500 (9.6% weight in total), and those names hold the top three spots in that index.

#3. Boeing’s YTD performance of +17% has been worth 400 Dow points, almost 10x the next largest contributor (MSFT, adding 49 point). If BA were flat on the year, the Dow would be down 2.4% instead of its actual 0.7% decline in 2018.

#4. On Thursday, an online aerospace trade magazine cited a JP Morgan report saying that the announced tariffs on steel and aluminum would only add 2% (at worst) to the all-in build cost of a Boeing airliner. Further, aluminum prices rose 30% last year with “little to no discernable effect on Boeing and most major manufacturers” according to the Morgan analyst.

#5. But… According to Boeing’s most recent 10-K (page 102), the company derives 55% of its revenues from outside the United States, far more than the typical S&P 500 company’s 30% split. China is the only country large enough to merit its own line item disclosure in Boeing’s financials (12.8% of revenues in 2017). That is a larger percentage of BA’s revenue than Europe in total (12.3%) and close to the Middle East (13.2%), which is a major end market for the company’s military aircraft.

That neatly summarizes the problem that investors have with the recently announced steel and aluminum tariffs. In the micro, they have little impact. Commerce Secretary Ross tried to make that point with a can of Campbell’s soup on live TV, much to the amusement of social media.

But writ large a global trade war could be very disruptive to international commerce. The Achilles Heel for the Dow is clear enough: hurt Boeing by pulling orders (for example), and the Average will suffer disproportionately. And, presumably, President Trump’s affinity for that measure will force him to take notice.

What happens next, however, is predictable enough; more headlines from all parts of the world promising like-kind tariffs in return. That has already started. EC President Juncker announced on Friday he was looking at levying higher tariffs on Harley-Davidson Motorcycles, among other US products. An odd battleground, you might think, until you remember that HOG’s headquarters are in House Speaker Ryan’s home state of Wisconsin.

The important question is what this kerfuffle means to valuation multiples on US stocks over the next 3-6 months. Friday’s FactSet Earnings Insight report put the PE multiple on the S&P 500 based on current analysts’ earnings expectations for 2018 at 16.7x, still above the 5-year average of 16.0x. The trade tariff news came as a surprise to many (President Trump’s long-held views on the subject notwithstanding), so it stands to reason that multiples have to reset lower to accommodate the news. But for how long and how much?

Three scenarios to consider, and our odds for each:

Option #1: A Passing Crisis (10% chance). There is substantial (if anecdotal) evidence that the president’s announcement on tariffs last week was hastily assembled. The White House has a modest chance at a do-over this week when it releases details. If it delivers a message that future trade action will be limited/targeted, the issue may fade from investors’ minds.

In this scenario, there is no lasting decline in valuations, and the White House becomes more circumspect about the topic to limit collateral damage to US equity prices.

Option #2: A Slow Burn (80-85% Chance). Trade was one of President Trump’s most powerful talking points during the presidential campaign, so we doubt we have heard the last of it. The next leg could well be targeted initiatives against China regarding intellectual property and trade policy.

This fits into our “Never just one cockroach” view of US equities in 1H 2018. The first one was the difficulty US equities had in February discounting both higher long-term interest rates and the chance of more aggressive Federal Reserve monetary policy. Trade/tariffs is now clearly the second unwelcomed critter. As troublesome as this is, it must be our baseline case.

At the same time, it is not enough to force a bearish viewpoint on US stocks. First, any developments here will take time. Second, investors have had plenty of practice tuning out political noise and focusing on rates and economic/corporate fundamentals. Both of those remain reasonably positive. Lastly, tariffs only last as long as political winds favor them. They are not forever.

In this scenario we expect equities to struggle for the first part of March, which has been our base case since mid February. Past that, earnings season kick in and investor confidence should return.

Option #3: A Real Problem (5-10% Chance). Political stability is a scarce commodity around the developed world at the moment. That lifts the odds that policymakers around the globe seize upon tariffs and protectionism as a way to bolster support and unify their fractured electorates. What starts as a limited skirmish over the price of steel and aluminum ends up as a full-blown global trade war.

The tricky thing about this scenario is that it will take time to develop and resemble the proverbial death-by-1,000 cuts. Since it benefits no one, we place low odds on it. The counterbalance that keeps it in our low-probability bucket is that European economies are now just recovering from the Great Recession, and China still needs the access to the US market to keep driving its export-driven economy.

This is not the 1930s, when Smoot-Hawley was enacted. The world economy is doing pretty well, not pitching over into global depression. Hopefully policymakers will want to keep the current momentum.